what is a 721 exchange and how does it work

What is a 721 Exchange And How Does It Work?

Adopting tax mitigation strategies is an essential move if an investor must grow their wealth. Doing this allows them to limit his tax burdens and keep enough income for reinvestments. A 721 exchange can be a great addition to your tax mitigation strategies.

As an investor, one way you can lose money to taxes is when you sell off real properties. The Internal Revenue Tax Code exempts some assets from taxes. But that might quickly change when you try to sell them. 

Sales of assets can attract taxes as high as 20-30% of capital gains. Fortunately, a savvy investor can legally avoid this huge tax charge and keep 100% of his money for acquiring new investments. 

Some investors have found that using a 721 exchange reduces the amount paid on capital gains taxes. They also have enough to reinvest in new properties. This post explains what the 721 exchange is about and how it works for investors.

Note: REIT means Real Estate Investment Trust. They are real estate companies that own real estate across several sectors.

UPREIT means Umbrella Partnership Real Estate Investment Trust. In this case, an investor contributes his property in exchange for a part of a REIT.

What is a 721 Exchange?

A 721 exchange (also known as a UPREIT exchange) is a type of like-exchange transaction. The exchange takes advantage of Section 721 of the Internal Revenue Tax Code.

Section 721 exchange grants tax-free treatment for partnership contributions(UPREIT is included). The 721 exchange allows you to let go of previous assets and acquire new ones simultaneously.

Eventually, you avoid capital gains taxes during this transaction. The purchase of UPREIT shares allows you to defer capital gains from the sale of your assets.

How Does a 721 Exchange Work?

You can carry out a 721 exchange by trading in real properties for operating partnership units (OP units) in a REIT. This transaction is done without paying any tax at the time.

The transaction is not deemed taxable because gains of the sale are deferred and no profit is recorded. You profit by avoiding huge capital gains taxes while acquiring shares in a REIT.

Your shares are only taxable when you convert your OP units to common shares, which trigger is taxable by the government.

Pros and Cons of a 721 Exchange

Every investment strategy has its highs and lows. Here are some advantages of using a 721 exchange.

Pros of the 721 Exchange

  • Passive Income for the Investor

Owning a REIT share allows you to grow your fortune without being actively involved in the day-to-day running of the company.

The REIT pays you dividends either quarterly or annually giving you a passive real estate investment opportunity. You also receive information about major decisions despite not being involved in any of them.

  • Diversification of Investments

REITs usually have properties across various geographic locations. Some would have industry or even asset class diversification. 

This is good news for you since this means the REIT will provide you with benefits like real estate appreciation and tax shelter depreciation.

  • Estate Planning

Physical real estate and other real properties can raise difficulties when passed down to a next of kin.

A 721 exchange enables you to transfer your properties to stable REIT shares. The shares can then be easily split, held, or liquidated by your heirs. You also benefit from dividends paid to you as you live.

Additionally, because the shares are passed through a trust, your heirs can avoid capital gains and depreciation recapture taxes.

  • Tax Advantages for the Investor

A 721 exchange absolves you from paying capital gains and property depreciation taxes. You can use 100% of your profits to purchase REIT shares.

However, completing the 721 exchange comes with certain charges. You should weigh these charges against potential gains and taxes you hope to avoid.

Cons of a 721 Exchange 

There are, however, several concerns that arise when considering a 721 exchange.

  • Inflexibility of Investment 

With the 721 exchange, you cannot perform another deferred tax exchange after receiving your REIT shares.

This is because REIT shares are not eligible to be used in other deferred tax exchanges, such as the more flexible 1031 exchange.

You are permanently attached to the REIT you choose to invest in, no matter how you later feel about it. Ditching shares will involve incurring capital gains taxes.

To avoid any possible regret, investors have to take great care in choosing a REIT they can work with long-term.

  • Loss or Gain Depends on REIT Management 

If the REIT decides to sell any part of an investor’s portfolio, this could affect the investor. This is because the REIT can return capital to the investor. He will be forced to admit a capital gain or loss in his tax filing.

The capital gain will attract a capital gains tax. This would cancel out the sole purpose of using a 721 exchange in the first place. 

This possibility shows that your funds and potential loss or gains are tied to how well the REIT is run. This is a factor you have no control over.

Example of a 721 Exchange

In one Case REI Capital Growth offers a great example of a 721 exchange implemented into their international commercial real estate fund.

Suppose an investor who owns an apartment sells it and buys another property of similar value. He holds it for roughly two years to show his intention of keeping the property. 

After which, he transfers the new property to a REIT in exchange for Operating Partners Units or shares. Once he does all this, he is said to have carried out a 721 exchange.

He may also decide to transfer the property into a REIT in exchange for OP Units. Once he receives his REIT shares, they are no longer eligible for any tax-deferred exchange.

1031 Exchange Vs 721 Exchanges: What Are the Differences?

A 1031 exchange is a tax deferment strategy under section 1031 of the tax code. You can avoid paying capital gains tax by reinvesting profits from the sales of a property into another property of the same kind.

For example, an investor can sell farmland and use the profits to buy an apartment building, raw land, or even other farmland. 

The investor is exempt from taxes if he uses all the money (or even more) from the former farmland to buy another one. 

Section 1031 of the Internal Revenue Tax Code stipulates that there is no capital gain as there is technically no gain accrued.

How Does it Differ From a 721 Exchange?

In a 1031 exchange, you typically invest in only one type of asset. The 721 exchange offers more versatility in invested assets.

A typical 721 exchange provides you with a steady stream of income. Your REIT shares allow you to earn dividends either quarterly or annually. This is not so with a 1031 exchange.

The 1031 exchange can provide investors with room to sell off assets while they continue to avoid capital gains tax. The 721 exchange does not offer this flexibility as proceeds from REIT shares are taxed.

Final Thoughts

Using a 721 exchange to defer capital gains taxes is a smart move. It comes with some benefits such as versatility of investment, steady cash flow, and ease of asset transfer.

But a 721 exchange also has a certain inflexibility about it. Loss and gain are tied to the management of a REIT you usually have no control over.

Overall, when deciding which tax deferment plan to use, it is important to weigh the pros and cons properly. 

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